Christine Benz: Hi, and welcome back to Morningstar's Individual Investor Conference. I'm Christine Benz, director of personal finance for Morningstar, and this is our session, Become a Better Index Investor.

We're going to just talk about how to select the best index funds and exchange-traded funds. We'll also talk about how to put them together in a portfolio.

I'm happy to say that we have three terrific panelists joining us here today to walk us through this important topic. Mark Balasa is here from the firm Balasa Dinverno Foltz. He is co-CEO at the firm. He is also chief investment officer. He has also been a long-time friend of Morningstar.

Jared Watts is also here. Jared is a portfolio manager for Morningstar Investment Management.

And last but not least, Ben Johnson is here. Ben is director of passive funds research for Morningstar.

Thank you all for being here.

Mark Balasa: Thank you.

Jared Watts: Thank you.

Ben Johnson: Thanks for having us.

Benz: We have a lot of material to get through, but I'd like to start with the index fund versus exchange-traded fund question. I think a lot of investors wrestle with this. Now that the dust has settled and some of the excitement regarding ETFs has died down or maybe not died down, is there a significant difference in what factors should investors bear in mind when trying to decide whether to just invest in a traditional index fund or to use an ETF. Ben, can you tackle that question for us?

Johnson: Yes. I think that's a question that's getting evermore difficult to answer by the day, and it's really gotten to the point where it almost boils down to a matter of personal preference. Do I place some sort of premium, some sort of value on the liquidity feature of an ETF and some of the flexibility of that wrapper vis-a-vis a traditional index fund? I think Vanguard in particular, whose ETF is really just a separate share class of their traditional index funds, has made that math increasingly difficult and made the decision increasingly subjective.

The other element, I'd throw in there is one of breadth of choice. So the breadth of choice is more extensive--sometimes for better, other times for worse--in ETF's vis-a-via index funds, but it's becoming an ever-finer decision and one, I think, that is more a matter of personal preference over time.

Benz: Ben, you mentioned that some liquidity benefit accrues to the ETF. Do you mean mainly that ability to trade intraday that you get with an ETF that you don't have with [mutual funds]?

Johnson: That ability to trade intraday, and I would hope that most investors aren't exercising that especially with core allocations within their portfolios. But if they place some sort of value on the idea of having that ejector button in case of an emergency, then that might lead them toward getting, say, broad U.S.-equity exposure in an ETF wrapper that might also be available in an index fund wrapper. But that is a very fine consideration. We're not talking about a black-and-white decision at that point.

Benz: So there is in some cases a tax-efficiency benefit to being in the ETF versus the traditional index fund, but in some cases it's not a benefit. In the case of Vanguard's equity products, for example, it's not a big benefit either way. You can get tax efficiency with either wrapper. Mark, when you think about tax efficiency, do you typically recommend the ETF, or how do you decide whether to use an ETF or a traditional index mutual fund?

Balasa: I agree with what's already been said. The distinctions are becoming kind of a subtle, if you will. If it's a well-run indexed fund, they should be able to really successfully suppress, I should say, the distributions. In some ways, perhaps it's a little more ironclad with an exchange-traded fund in terms of controlling your tax liability, but for most part, it's a subtle difference. I think that's one of the key advantages of ETFs and index funds over traditional actively managed funds, though.

Benz: Jared, can you talk about why ETFs and index funds in general tend to be more tax efficient certainly than say your typical actively managed product?

Watts: Sure, absolutely. And it's really more about the overall construction and mechanics. The ETFs are more tax-efficient, simply because of the design where they have the ability to basically neutralize some of the tax impact that an active manager or mutual fund would not be able to do since they are required to make a distribution once per year.

ETFs have more flexibility in the overall timing of when that would take place just through the buying and selling of the underlying shares. So it's more of a structure type of difference between especially active mutual funds and ETFs.

Benz: Just to be clear, index products and ETFs will only be tax-efficient in relation to capital gains. If the product is spinning off some sort of current income, it's not going to matter whether you own it in an ETF index fund or in an actively managed product, you pay the tax bill either way?

Johnson: That's a really important point. At the end of the day, if you have a capital gain in that position that accrues with time, when you go to sell it, tax efficiency becomes irrelevant. It's the tax efficiencies sort of during the holding period of that product, which as Jared pointed out, primarily springs forth from the way the portfolio is managed. It's a passive portfolio. Turnover tends to be much lower in the case of the ETF, the uniqueness of the in-kind creation and redemption mechanisms. So they are not taking cash directly from shareholders. They are taking securities directly from authorized participants and exchanging those.

So there is that sort of mitigating of the potential for taxable events in that wrapper. The source of that tax benefit is accrued over the holding period, but it does not necessarily mean that you're off the hook for capital gains taxes when you go to sell these instruments.

Balasa: I'll make one small point between ETFs and index funds. If you are a small investor--let's say you're saving for your children's education, or they are doing it for themselves, they are putting in monthly deposits or are buying it monthly--ETF transaction fees can add up as opposed to if you go straight to the fund provider with small purchases, assuming you've met the minimum [investment threshold]. That's a more cost-efficient way to do it because you don't take a charge. So it's small difference perhaps, but for people making small contributions, there is a difference.

Benz: And there are increasingly, though, commission-free platforms, right, Mark?

Benz: I think a lot of investors who are looking at index products might naturally think the cheapest thing is the one that I want, and generally speaking, it's not a bad rule of thumb. But are there other nuances? So, say, I'm looking for U.S.-equity exposure, should I just go with the cheapest provider for that fund or are there other considerations I should bear in mind?

Johnson: I think nine times out of 10 that's going to get you in the right church. Getting to the right pew is going to be a bit more sort of granular decision. So, cost gets you very far down that road. The cost component is becoming finer all the time, too, especially if you look at in exchange-traded funds, for example, where the majority of the assets are. The top 100 exchange-traded funds right now account for three quarters of assets. That top 100 out of about 1,600 funds has an average asset-weighted expense ratio that is half that the remaining 1,500 funds. Those fee comparisons are being measured in fewer basis points than I can count on one hand right now. The needs become more granular in terms of assessing. So looking at tracking performance, sort of the implicit cost of ownership and how well is this portfolio tracking. And personal decisions [also play a role]. As Mark alluded to, transaction costs are important to keep in mind, too. How liquid is that fund, and how am I accessing that fund? If I'm a Vanguard client, I can trade ETFs on a commission-free basis. If I'm a Charles Schwab client, I can trade a select list of ETFs on a commission-free basis. It's a great thing that it's come to this point that we're literally making decisions on the basis of basis points, but they're very fine comparisons.

Benz: Jared, when you think of looking at products for client portfolios, do you always go with the cheapest product, and maybe you can give us an example where you haven't opted for the cheapest product because you think for whatever reason a slightly more expensive product actually does the job a little better?

Watts: Yeah, absolutely. So, at a high level, the answer is, no, we don't always go for just the cheapest product as defined by just looking at something as simple as the expense ratio, for instance. Many times you'll find that when you consider all the expenses that are involved, whether that be the trading expenses or just the bid-ask kind of the trading efficiency or liquidity and you put all those expenses together, you come to a total cost. So you should actually look at each ETF based on your total cost estimate and then determine which one is more favorable.

Benz: What items am I looking for? Say, I'm looking at some information about an ETF. I can find the expense ratio, it's right there. How about the other factors? Where do I find that information, and what numbers specifically should I be attuned to, to try to get my arms around the total cost?

Watts: Sure. In trying to gauge the total cost, there are a number of different components. However, I think Morningstar does a great job of providing a lot of those individual metrics. So you can actually look at, for instance, the bid-ask spreads. How is this ETF trading? When I go to trade, am I going to pay an additional cost because the ETF is not trading as efficiently?

For someone like myself, I look at a lot of additional costs because when I go to take a position or exit a position, I tend to take a very large position. Therefore, there's always the issue of moving the market in that particular instrument. Those are a couple of the metrics.

Additionally, you have to be very much aware of your personal situations. In other words, how am I going to use this instrument? Am I going to use this instrument over a short-time horizon? Therefore, I should probably pay more attention to the liquidity component because that at the end of the day will allow you to have a lower cost. But if I'm a buy-and-hold investor, I want to buy this position and keep it over a very long time period, then you're probably best-served at looking at ETFs that have a lower stated expense ratio.

Benz: Mark, how do you assess that question when you are looking for index products for client portfolios? Should we look at all those factors? Are there any other issues, index construction, for example?

Balasa: That's a great set of things to keep in mind, but for us, most of our clients are long-term investors. The lowest cost is really important to us. Tax efficiency is important to us. ETFs are fabulous at that, in general, right. But for us, in terms of the portfolio construction and the product provider, those are important to us. There are differences between the S&P 500 and the Russell 2000 and Dow. Each of those has a little bit of different weightings and different schemes in terms of how they come up with their large-cap or their small-cap indexes.

The other thing is some of the ETFs and index funds that now have exposure to different factors. There would be the great example for us of where we want to pay attention to how that's calculated and how that's constructed. To your point, how do you bring all those together in a uniform way? There are some great tools on Morningstar's website. Some of the product providers, the ETFs and fund families, Vanguard, State Street, Barclays, and others, have tools that allow you to kind of put these things together to have a little bit of insight to where that overlap is occurring and where it isn't.

Benz: I know asset size can make a difference in the realm of exchange-traded funds in particular. You might incur higher trading costs if it's a smaller ETF. Ben, can you talk about how that works, and also what would be the size that you would consider critical mass, where you should feel comfortable investing in that ETF? And where would you say it's kind of a danger zone, where you might have some of that risk of the portfolio trading out of line with the securities portfolio?

Johnson: Size is very important to take into account because I think it's indicative primarily of viability--so will this product be around three to five years, hence--and then liquidity as well. There are any number of market participants who'll look at products that are smaller in size and say, "I simply can't allow this on my platform. I can't bring it into my portfolio because if I need liquidity to exit this position, I'm not convinced that it will be there."

We use about $100 million in assets under management as a general rule of thumb. Funds that are above that as being viable; funds that are below that and sort of stagnating--so not seeing sort of new flows at the margin--as being somewhat more suspect.

That said, it's important to also look at the sponsor, as Mark has alluded to, because I would have a much greater degree of confidence in a product that has say $75 million in assets from iShares or State Street or Vanguard being around five years from now compared with one that's sponsored by a second- or third-tier player that doesn't have that heft, that scale elsewhere to sort of subsidize and allow that strategy to germinate.

The other thing I would say is some sponsors are more apt to sling spaghetti at the wall and see what sticks and be somewhat impatient in terms of allowing products to season than others. There are some that are very patient and will let smaller products sit out there and season and allow sort of the winds to turn in their favor over time. Others have proven less patient. So size is a good first step, but not the end-all and be-all of the assessment.

Benz: We are taking questions from our viewers as we go along here. One good basic question came through, and it's about whether someone should hold traditional index mutual funds or ETFs if the goal is to get total U.S.-equity market exposure in a taxable account? Where do you all come down on that question: ETF or index fund?

Balasa: For us it has been discussed very efficiently either way. When ETFs first came out, that was perhaps a little bit more challenging, but in today's market with all the products, it's very easy to construct a complete U.S., and for that matter, global portfolio with either set of products.

Benz: Is there a specific total U.S. market ETF that you all would favor over others? Or is it just sort of roughly equivalent based on expense ratios?

Johnson: I think it depends on portfolio construction. It depends on preference. It depends on access. I think VTI…

Benz: It's Vanguard's Total Stock Market Index ETF

Johnson: Correct, is one that we tend to think is one of the better ones out there, given that it offers very broad-based exposure, has a very low fee, and has a very solid parent firm sponsoring it. That would be the one I would put out.

Benz: I would like to talk a little bit about the active-versus-indexing decision, and I know that a lot of our viewers, readers blend the two strategies together. I know that, Mark, in your practice you do, as well. So let's talk about how investors can make good decisions on that front, where to index and where to go active. Mark, maybe you can talk about the approach that you've taken in your firm. I know that you told me that you're all passive U.S. equity. Where are you using active products?

Balasa: Actually all of our equities, whether domestic or international or actually even emerging markets, they are all indexed or passive. On the bond side of the portfolio, we have about a third of that that's indexed and two thirds that's active. So for us, I mean our history was we started with all active managers way back when, and through disappointment and discouragement, we eventually became all indexed or passive. So I can share some more stories if you want to hear that. But we think in the equity side, it's very compelling to use the index or passive approach, and there are so much data supporting that.

The bond side is trickier. The bond market is just a different animal. For us because of the difficulty with what the Barclays Aggregate Bond Index is, especially for taxable investors, it almost by definition led into creating something other than the index for yourselves. So that's where we have active managers.

Benz: I want to discuss bonds in more detail in a minute.Jared, I'd like your take on that question. Within Morningstar Investment Management, is there kind of shop view of spaces to use actively managed products and where you should definitely go index?

Watts: Absolutely. We've spent a lot of time giving thought and doing the research on the subject, and we've concluded that you can actually benefit by having exposure to both. So we have a very detailed active-passive methodology, where our research has shown that there are certain asset classes that are so informationally efficient, that an active manager has a very tough time of beating the benchmark, both in the short- and long-term.

However, on the flip side, we also have shown that there are asset classes such as small-cap value, international developed small cap, for instance, and then a couple other asset classes that are not as informationally efficient, and you have a much higher probability of choosing an active manager that will beat the benchmark from a risk-adjusted standpoint. And there are lots of statistics out there for investors to look at. They can see simply the number of active managers within a particular asset class or market exposure and how many of those active managers in the entire universe have been able to beat the index that serves as the proxy for that exposure over both the short term as well as the long term.

So, I think that if you feel confident that you're able to select and identify superior managers, that there is a benefit to selecting active managers for those particular spaces. But then, for instance large-cap core, it's so efficient there that many times you are better served by just using a very low-cost beta product, such as an index product or ETF.

Benz: Would you throw foreign developed-markets large cap into that realm, as well, that very informationally efficient area?

Watts: It used to not be the case. However, over the years, the market has become quite informationally efficient, and the number of overall managers that identify themselves in that space have slowly, but surely not been able to beat the index. So as time has gone on in the international developed space, active managers as a whole have not been able to beat the index from a risk-return standpoint currently versus, say, 10, 15 years ago where more active managers were able to actually beat the benchmark there.

Benz: It's not that the managers are getting dumber. It's really just that those markets are becoming more efficient, and it's harder for managers to have an edge. Is that the idea?

Watts: We think so.

Benz: How about fixed income? Mark mentioned that that's an area where they do heavily emphasize active management. Is that the case in Morningstar Investment Management, as well?

Watts: Again, when you look at the statistics, it actually says that active managers have not done a very good job, and it's quite surprising because you would think that an active manager could really add value in a space such as fixed income, where the market in general tends to be a little less efficient in the way it trades. There are many different securities within fixed income that are very illiquid.

Also, there is a lot of value that can be added through credit research, for instance. However, when you look at the stats again, it shows that the number of active managers across many different fixed-income sectors have not been successful at beating the benchmark.

Benz: Ben, within your group, I know you spend a lot of time looking at which areas are best indexed and which are better off using actively managed products. Where are categories where you would say absolutely don't index? Are there any that come to the top of the list?

Johnson: "Absolutely don't," I think it's all about relativity. I think your odds of finding a winning bond manager are much better than your odds of finding a winning U.S. large-cap equity manager. There is no cut-and-dried sector where it's clear-cut that passive is a bad bet. I think the worst bet is probably in the realm of fixed income, just given the nature of the underlying benchmarks, you could effectively call things like the Barclays Aggregate Bond Index busted for all intents and purposes because they are just not reflective of a sensible bond investment portfolio.

So that said, what the ETF arena has done is Humpty Dumpty fell off the wall and became each of the individual sectors of the Barclays Index. So you can go about and create a sensible portfolio, which is actively managed using passive building blocks. We're seeing more and more of this all the time, in especially the realm of the ETF managed portfolio space. And I think simultaneously what you have is index providers working furiously in the background to build better bond benchmarks.

Benz: We have kind of addressed the bond issue tangentially, but like to address it head-on because in looking at some of our user questions in advance of the conference there is so much concern over the bond market, what rising interest rates could mean for people's bond portfolios. And I think this intersects nicely with our topic today, where even committed indexers are wondering should they be investing in that Barclays Index for their core fixed-income exposure. The index has that heavy government-bond exposure? Is it the right mouse trap for investors seeking a core fixed-income position? Mark, can you tackle that question?

Balasa: For us, we break it up into two pieces, tax-deferred accounts and taxable accounts. That's another layer of decision that has to be made here. But for us the simple answer is, no, it's not a complete solution, as you said. At this point, because of our government's borrowing, a government-bond index in many ways doesn't have Treasury Inflation-Protected Securities, and doesn't have international bonds. When [the index] came about the bond world wasn't as diverse as it is today.

Again, that's even more complicated if you look at taxable investors. For us it's looking outside of that; it's trying to look at what the risks you have going forward. Tapering is going to potentially end this year, and potentially rates are going to go up next year. How do you navigate that environment? Of course the traditional answer is to shorten duration [a measure of interest-rate sensitivity]. Look at the credit quality of your portfolio. So certainly those are two things we were doing, as well. But for 2012, 2013, and this year, we also are putting a little bit more emphasis on multi-sector-type managers who have more breadth of opportunity and can be more defensive. So for us that's part of our solution.

Benz: Can you give some examples of the multisector funds you are using?

Balasa: Sure. So a couple of examples, one would be JPMorgan Strategic Income, which is kind of a bottom-up manager. Another would be PIMCO Unconstrained Bond, which is more top-down in terms of their view in how to construct a multisector portfolio. So the idea is to get different ideas because everyone has a little bit of a different cookbook for what a multisector bond fund looks like. But get something that complements one another; we also use BlackRock as an example.

Benz: So you would use multiples together in a client portfolio.

Jared, let's discuss that question for you when you think about the typical individual investor trying to get that good ballast in their portfolio with the fixed-income exposure. What are the pros and cons of using a Barclays Aggregate Bond Index tracker for that role, and what other ideas might investors consider?

Watts: When we look at client portfolios, we tend to basically create a very well-diversified portfolio that has many different exposures. The Barclays Index over the last decade has undergone material changes in just the structure in what its holding and how much the sectors are represented within the aggregate index. For instance, it didn't used to have so much government exposure. It used to be, in our opinion, a more balanced index for investors to be able to hold in a larger portion as their core holding. However, over the years as you pointed out, it's become a lot more tilted toward government sectors in exposure to the tune of upward of 70% when you include the agency component. So what we do is basically look at the Barclays Index as perhaps a starting point, a core position still, but you can add a lot of value through adding additional exposures.

As you mentioned, you can add a high-yield exposure; you can have exposure to TIPS. And then for more conservative investors, because we tend to look at it from a risk standpoint in classifying each investor type, for the more conservative investor, you likely want to have more short-term exposure than the Barclays Index provides, as well.

Benz: How would I determine these percentages of how much to hold in the Barclays Index versus some of these satellite holdings?

Watts: There are lots of tools out there that help provide and give guidance on your overall asset-allocation policy because that's really what we're talking about here as an investor trying to come up with a very long-term, well-thought-out strategic asset-allocation policy that they can then implement through some of these products. Our view is that the Barclays Index would just be one little piece of the puzzle in your overall asset-allocation policy, and that it would tend to represent your intermediate-term bond exposure.

However, that leaves a lot of additional exposures that you can benefit from having or maintaining such as short-term bonds, perhaps some exposure to long-term bonds, and then also adding high-yield and a number of other exposures. There are tools out there that a lot of companies will provide to help people with the decision on how do I come up with an asset-allocation policy. Or you can go to your trusted advisor, or perhaps you're already using an advisor, and they can help you formulate the appropriate strategic asset-allocation policy for you.

Benz: Is anyone to your knowledge talking about building a better bond index, one that is perhaps more reflective of the exposures that investors might actually want in their portfolios?

Watts: Absolutely. Of course, all the active managers are looking to basically constantly improve the characteristics of the Barclays Index, and that's really how they're trying to add value and generate kind of the excess return, or what we term as alpha. So they are constantly doing that.

However, on the index side or the more passively managed products side, we see a number of ETF vendors that are looking to come to market with a better solution. Perhaps something that is advertised as an enhanced Barclays Index. So I would say, absolutely a lot of the conversations that we've had, the vendors have expressed interest in developing products that would improve upon the current Barclays Index.

Benz: Ben, when we look at fund flows, we see that there has been a strong investor appetite for a lot of these noncore fixed-income categories. We've seen bank-loan funds getting very strong flows and the nontraditional bond category, as well. Are you concerned that some of the bond types that investors are flocking to may not be that ballast for them in their equity portfolios that they need?

Johnson: Very concerned, and I think the flows into in particular, I would say, the bank-loan sector, the high-yield sector are indicative of sort of a memory loss on a whole and on the part of end investors, forgetting why they hold bonds to begin with. We hold bonds, not to be glib, because they're not stocks and they diversify away equity risk.

So when you look at people flocking to, say, high yield or to the bank-loan sector, what you are doing is you're just piling on a very similar delivery mechanism for a very similar type of equitylike risk. So you are kind of taking away some of the ballast in your portfolio that's provided by bonds. Are the expected returns for the Barclays Index great right now? Absolutely, not. The short end of the curve, if you take inflation into account, there are some sectors that expected returns are negative, but they are there as a strategic component of one's asset allocation for a very long period of time.

What we are going through right now is some short-termism that's focused around the fear of rising interest rates, which will have negative impacts to sort of the capital value of bond portfolios dependent upon their duration.

But when you move away into sectors that are delivering equitylike risk, that's scary in my point, and I think people have been holding their noses and have to kind of take the pinchers off their nose for a second and have another look at what it is they've been doing by piling into bank-loan funds. And high-yield bank loan funds, I think, now are going on I forget how many consecutive weeks of inflows, but it's an asset class that over the course of the past 12-18 months has grown many-fold in size just on the basis of new investor capital flying into an asset class that not all that long ago was monthly illiquid. So it's a cause for concern.

Benz: I think we could spend the whole session talking about fixed income. It's such an important topic, but I'd like to just tackle one last question, and today the biggest and most popular actively managed exchange-traded fund is Bill Gross' big PIMCO Total Return ETF. Do you all think that there will be increased entrance into the active ETF space, and if so, what categories will they come up in, and who will have success there?

Balasa: I would assume the appetite is huge for that because the structure of an ETF has its advantage. We already talked about lower-cost potentially and better tax efficiency. And for the provider there is less administrative costs; you don't have to fund a help desk. That all leads to potential advantages in terms of the ETF structure.

The trick has always been, how do you get that transparent in a way that they can do their creation or redemption units? So I think the appetite is there. It's just, can they get the right structure past the SEC to open up the floodgates. I'm talking to many different fund providers. I know the appetite is there. It's just finding the right bag of tricks that will get past the SEC.

Benz: It's interesting in the case of PIMCO Total Return; upon its launch, it opened up a big return advantage versus the traditional mutual funds. That seems to have shrunk a little bit. Do you think it was mainly just that it was more nimble and maybe able to own a few things?

Johnson: Yes. That's exactly it. Straight out of the gate, that portfolio was PIMCO's greatest hits. It wasn't a $250 billion portfolio on day one. They were basically able to take sort of the choicest cuts off of PIMCO's pick list, which allowed the ETF to start very strongly out of the gate.

If you look at the landscape, and I think in many ways PIMCO caught lightning in a bottle, in many ways the success of the ETF was a mathematical inevitability. If you look at the very well-known parent firm, Bill Gross has a decades-long track record already with PIMCO Total Return [mutual fund], and the math, especially from an individual-investor perspective, this is another note in what's been a long song now of ETFs being sort of this democratizing force and delivering institutional type exposure and, in this case institutional type pricing, to an end investor.

It cuts out all of these intermediaries and all these costs that Mark alluded to. And all of the sudden I can get PIMCO Total Return in an amount as low as a single share through my online brokerage account, at a fee that's only marginally higher than the institutional share class. So combine a strong track record, a great manager long stayed in this market with just the math that just makes you say, "Of course, I'm going to opt for that option," and I'm going to be hard-pressed to say that there are many out there that can re-create that type of success.

Benz: Going forward, though, now that the ETF is bigger, if someone could buy, say, the PIMCO [Total Return mutual fund] institutional share class versus the ETF, do you think there will be a strong benefit for the ETF?

Johnson: Again, you get into that granular math. So if I have PIMCO Total Return [mutual fund] in my 401(k) account, I'm just going to continue to drip in every two weeks more money into that. If I have a taxable account off to the side, where I otherwise would only be able to access one of the mutual fund share classes, I'm probably going to look to add money to the ETF.

Benz: I want to tackle some viewer questions. One, and I think it's a great one, is about smart beta. The question is have smart beta funds and ETFs run their course, or are they better than market capitalization-weighted indexes? Jared, let's start with you. Can you give us just a quick layperson's discussion of what smart beta is?

Watts: Smart beta actually includes a number of different strategies. It includes what we would call factor-based investing.

Benz: And what does that mean?

Watts: Factor-based investing at a real high level is basically just an investment characteristic that helps to find the risk and return behavior of a stock. That's it. The early research in the first factor that was discovered was the market. So that's beta. And of course that helped basically everyone price stocks through the capital asset pricing model.

Later, research came out, and they said, "Oh, well, we know that there are these other factors that can also help better explain individual stocks and their risk and return characteristics." And some of those were size, valuation, momentum, and quality. And those came out around the '90s from academia. Then basically from there, they did additional research and came out with more factors, which was basically volatility, liquidity, and then a whole host of different hedge-fund-like factors. That at a high level is really what factors are and the thought behind factors is that historically, if you go back in time and you isolate these factors that they can provide a better risk and return advantage over just holding the market factor.

That's really what factors are. That's included in the smart beta definition--or at least if I listen to every ETF provider out there define smart beta--that's probably the average explanation and definition. It also includes things like different commodity products in the way that they address some of the issues with the commodity space, especially, when you go to roll their various futures products. Sometimes you get stung by a little nasty phenomenon called contango, which really eats away at your return. There are different products with methodologies to try and avoid that particular experience; those are included in there. And then, again, there's a whole host of others. For instance, fundamental weighting, so in other words, not using cap-weighting but basically weighting upon different factors either equal or based on a company's fundamentals, for instance. ETFs basically have developed a number of strategies that try to isolate all these different common factors in a stock basket, and then they offer that particular exposure within an ETF product. That's really what smart beta is when you hear people talking about it.

Benz: Getting back to the question, if someone is considering just using a capitalization-weighted index--a traditional index that is weighted by company value--or assembling a portfolio composed of these different factors, how should they think about that decision, and how should they decide which is right for them?

Watts: If you just heard what I said before as far as the explanation and you have absolutely no clue what I'm talking about, then you probably need to stick with cap-weighted and just look at the world as many institutional and best-practice portfolio firms do, which is looking at asset classes and constructing an asset-allocation policy by looking at asset classes.

Factors are quite valuable for some firms. They look at their entire asset-allocation policy through the lens of factors, and they construct their exposures by looking at factors. However, it's still more common for individuals, as well as institutions to look at the world through the asset-class lens, meaning they look at their various exposures by defined asset classes, like, for instance, looking at Morningstar Style Boxes. You have large cap, small cap, mid cap, and you have different styles of growth and value. So they construct their policy by looking at and constructing different exposures with that methodology as opposed to using factors.

Benz: Mark, I'd like to hear your take on that question because you told me that you do, in fact, incorporate factor investing into your practice. Let's talk about what factors you aim to exploit by focusing on them?

Balasa: I think for us it's a really valuable component to our portfolio construction. The explanation is great, but in the end to help simplify this, for us, we think the four factors that have the most value are: 1. Value, meaning value stocks do better than growth; 2. Capitalization, small does better than large; 3. Momentum, high-momentum stocks do better than low-momentum stocks; and 4. Profitability. In 2012, Robert Novy-Marx came out with a paper about profitability.

Those four factors are the most potent, if you will, in terms of finding almost nickels and dimes and quarters for free on the street. They're just there to be had by exposing your portfolio to these factors.

One of the things that's interesting about it, too, the correlations between these factors are low. So they're most potent when they're combined as opposed to independent. So coming back to the asset-class description, where you would tend, in the past, to have [exposure to] large, small, value, and growth asset classes. That's good, but for factors, these four in particular can be additive to the portfolio. The more you can integrate them, the better off you're going to be. For some of the core products that are out there, trying to do that to us are very interesting.

So AQR is an example there; iShares has now come out with their enhanced product on the ETF side that takes some of these factors and brings them together. Then there are some institutional people like DFA and so forth that do it, as well. But for us, we think it's a really important piece, important in terms of putting together a portfolio to take advantage of what's just essentially an additive part, a way to construct a portfolio.

Benz: Do you use core cap-weighted indexes as sort of the core, and then use some of these factors as satellites?

Balasa: We have up to this point, but that's changing because of some of the work and some of the stuff that's coming out. In the past we would be more asset-class-based. But we're looking at transitioning to more core-based for large-international and in large-U.S. assets. And there are now also products for core small U.S. So it's not in every asset class. It's not in emerging markets and not in small international yet. But in some of the bigger pieces of the portfolio, there are core products that are available.

Johnson: Before I get into the specifics of that, I'd just like to add a little bit on this whole topic because it ties back into what I was saying about sort of the democratizing, or the leveling force that I think ETFs in particular have had on this market. And what they're doing now is they are using as their foundation a lot of great work that was produced by a lot of very smart people just down the street here at the University of Chicago and bringing it out in such a manner that it's available to anybody. That creates a huge learning burden because not everybody here, I know I didn't get an MBA, at least not yet, at the University of Chicago. So it's something that really changes sort of the language, changes the discourse around the portfolio construction and how we think about investing in equities in particular.

So there is a big learning burden here. There is a lot of sort of marketing hype around what we are calling the strategic beta space. We think the word smart lends certain positive connotations that aren't always necessarily deserved and also would infer that anything that's not strategic or smart is in some way unintelligent or less intelligent, which we know is not the case. But there is this big learning burden and there is a lot of marketing hype. So this creates danger for investors as they encounter these products, as they might not know the ins and outs of factors. And there is this really appealing name and this appealing track record, some of which might be the result of just a great back test that was the best-looking over the long run of very bad ones. People don't launch products based on bad back tests, much the same way you don't launch pharmaceutical products that have horrible negative side effects. It's just not going to happen. So investors should proceed with caution and should look for products with sound academic reasoning, economic intuition, good sponsors, and low prices. It's as simple as that.

So getting to the question of DFA and Vanguard, we're talking about two very different approaches, at least to date. Vanguard is beginning to wade into sort of the more strategic, more factor-driven models. They launched a low-volatility product, in particular, last year. Vanguard to date is very monolithically cap-weighted in terms of their product lineup.

DFA now going on over three decades has been actively trying to exploit these factors--in particular the size factor, the value factor, and, more recently, the profitability factor--in a very systematic way. They are not an index firm, but they look to isolate these things. They don't go out and pick stocks, they look for characteristics. If I'm just out there and I'm not saying, "Oh, I want a Big Mac, a Whopper, or something from Carl's Jr., but I'm just looking for protein, fat, and carbohydrates." That's what DFA is doing. They're not picking the best burger, they are just looking for the one that has the attributes that they want, that they think can deliver superior returns over time.

[The fund firms are] two very different animals, right now. DFA is out of reach, frankly, for a lot of people, individuals in particular, who aren't working with an advisor that is part of the DFA program, or that don't have a DFA fund on their 401(k) platform or through a 529 college-savings plan. DFA works primarily with vetted advisors and vetted institutions.

Vanguard, obviously, is accessible to virtually everyone, and again, is moving in sort of DFA's direction in terms of thinking about new product development and how to isolate these factors.

The last thing I want to add, we talked about nickels and dimes and picking them up on the sidewalk. That takes patience. A lot of these factors, not unlike anything else in the world, will go into and out of style over time. They are no different than fashion that what we see across sectors, the value premium will pan out over time, but it's going to have some lumpy sort of returns in between. Patience is absolutely paramount.

Watts: I would agree. I'd just add that, it's important for people to recognize that they already have exposure to many, if not, all of these factors.

Benz: So if they have a well-diversified portfolio, they don't need to go out and cherry-pick individual factors?

Watts: Absolutely. When you go out and you want to add momentum to your portfolio, how do you size that? That's the big question mark. Institutions and the more sophisticated managers haven't been able to really figure that out in a systematic way. If they're not able to do that, I would just ask: Is that something that an individual investor feels comfortable that they can be able to back into? Because those factors are constantly changing, as well as your portfolio's factors are constantly changing. It's very difficult without very sophisticated and expensive software to be able to even identify the factors that you currently have exposure to. So you have to be very careful in how you are using these tools, and that would basically be our opinion.

Benz: I think we're going to have to let that be the last word. I want to thank all three of you: Mark Balasa, Jared Watts, and Ben Johnson. You've all provided a terrific perspective on this important topic. I think we have much more we could go through, but unfortunately we're out of time. Thank you so much for being here.